Corporate Governance – The Greatest Challenge for Start-ups?By Raymond Moh
From the collapse of biotech firm Theranos to the recent bankruptcy of crypto exchange FTX, the prevailing need for proper governance in privately-owned companies is gaining more attention. These high-profile start-ups, which can be sizeable in terms of valuation, do not fall into the purview of regulators or are not publicly listed. Therefore, such regulatory arbitrage or the lack of public scrutiny may result in the firm being susceptible to governance failures if sufficient checks and balances are not in place.
These issues create an opportunity for all start-ups, big or small, to reflect upon their current practices and lessons that can be drawn to strengthen their governance, given the limited resources.
Exploring the Pillars of Corporate Governance
Let us first appreciate the principles of corporate governance, which is widely defined as the system that directs and controls companies. According to OECD, it covers a set of relationships between the company’s management, its shareholders, its board, and other stakeholders. Corporate governance manifests itself through the four core principles including accountability when the corporate actions and conduct are justified; transparency, when truthful and timely information about the company’s position is disclosed to stakeholders; fairness, when all shareholders and stakeholders are treated equally; and responsibility, when the board of directors acts ethically and maintains the best interests of the company. Reflecting these principles in practice can involve several modalities and they serve to prevent firm decay over the long term.
Benefits to Adopt Good Governance
A fast-growing start-up requires quick access to external funds at a manageable cost. A company that is seen as stable and capable of mitigating possible hazards will be able to borrow money at a lower interest rate than one with less sound corporate governance. In some industries, companies may discover that their investors are willing to pay a premium if they have a solid governance structure in place.
Furthermore, according to research by the London Business School, strong corporate governance is one of the most critical variables leading to increased organisational performance. Implementing specific steps, such as separating the CEO and chairman of the board positions, hiring the right balance of non-executive directors, and bolstering internal controls, all contributed to faster development.
In a similar vein, the Diligent Institute reported in 2019 that the best-performing companies in corporate governance within the S&P 500 index had a two-year return on investment 15% higher than the poorest-performing companies. It also revealed that "businesses with corporate crises caused by governance inadequacies underperformed their industries by 35%.” These businesses lost nearly $490 billion in shareholder value in the following year. Although these statistics are derived from larger corporates, they are still relevant references for start-ups especially those that experience explosive growth but are not time-tested.
The conventional expectation is that corporate governance is the responsibility of the board and executive management of the firm. However, the highly complex business environment warrants collaboration or influence from stakeholders such as investors and employees.
Start-ups and their investors have a symbiotic relationship. If investors do not exert influence on their portfolio companies to adopt or strengthen their governance, cracks that surface later due to the accumulation of bad practices can have irreversible damage and come back to haunt the incumbent investors.
During the heydays when venture capital is chasing a limited pool of worthy start-ups, expectations of the latter having a sound governance structure are low for fear of missing out on opportunities. Investors should ask robust scenario questions to assess the corporate governance quotient (CQ) and follow up with resources to address such gaps post-investment.
In tandem, investors should not perceive a company as having a higher CQ just because there are reputable names on the board. For example, in the case of FinTech, window-dressing the board with former financial regulators and professors from renowned universities is not uncommon. In some circumstances, institutional investors may not have a board seat. Nevertheless, they can and should still exert influence on corporate governance matters by incorporating relevant clauses in the shareholder agreements, thereby building discipline and engagement opportunities with their portfolio company.
Most start-ups with ambitions to become unicorns dabbled into disruptive technology or business models. Many corporate decisions were made by directly going through the process of voting through familiar faces. Thus, constructive debate and hard conversation are missing. Such companies are chartering into unknown waters. It is precisely this blue ocean market that they need to solicit diverse viewpoints to identify plausible risks while chasing opportunities that propel their firm’s valuation.
Founders and investors can work together to form a board of directors and independent directors with diverse backgrounds. Independent directors are seasoned professionals and should not have any conflict of interest so that they can be effective devil’s advocates, and introduce outside viewpoints which bring about cross-pollination of ideas and pre-empting risks unknown to the founding team. For example, providing perspectives on hard deep-tech topics and asking probing questions on downside scenarios can jolt the executive management to re-evaluate their business decisions.
While it is initially challenging, start-ups can learn to properly manage their resources to implement the relevant mechanism. Start-ups that require external expertise but do not have the financial resources could invite advisors who have a similar vision but do not expect much monetary remuneration. For instance, such advisors might yearn to publish a paper together with the company or just want to be recognised in the field. At the very least, founders can turn to investors for free mentoring, as the latter has seen a lot more scenarios within their portfolio companies or can bring in relevant professionals through their network. Therefore, active engagement between investors and executive management is necessary.
The board can also design appropriate metrics that shape behaviours. This goes beyond financial performance and encompasses elements like ethics, corporate social responsibility, culture alignment etc., which engenders transparency, inclusion, credibility, and accountability - the hallmarks of sound corporate governance. There should also be a mechanism to remind and articulate the boundaries, conduct and the need for disclosures to stakeholders in the path of achieving the next major milestone. When these are systematically tracked, they are cascaded down to the rank-and-file and in turn keep the management in check, forming part of the organisation’s culture.
Numerous start-ups provide employee share options to key employees. Executives can invite the more open-minded core employee to participate in board meetings as observers and encourage them to share their views since the interest is aligned. Start-ups can also implement whistle-blower policies and create safe channels for employees to report fraudulent business practices to independent directors or even investors, without jeopardising their career progression. These are not expensive affairs and start-ups who see the long-term value of such practices will commit to building such processes.
The right balance of guardrails allows a start-up to grow faster and further with less risk. On the contrary, without such, it is only a matter of time before the roof crumbles. For many young entrepreneurs, practising good corporate governance is a quest for continuous learning, improvement, and self-reflection. This is a good start to a journey to achieving a sustainable path of corporate excellence.